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One of the more unpleasant surprises that can hit a taxpayer occurs when you sell personal property, rental property or assets from your small business. This tax surprise is often associated with depreciation recapture rules.

Defined

Depreciation recapture refers to reducing the cost of an asset sold by prior period’s depreciation expense to determine whether taxes are owed on the sale of an asset and to determine the type of tax that must be paid on the sale of the asset.

When you have business property with a useful life of over one year, you often have the ability to deduct part of the cost of that property over the estimated useful life (recovery period) of that property. The most common users of these depreciation rules are small businesses and rental property owners.

When the asset is later sold the IRS wants you to determine if any tax is due as either ordinary income or as a capital gain.

A simplified example: Assume you run a small business out of your home. You purchase a new computer used 100% by your small business. The cost of the computer is $3,500. IRS rules determine you may recover the cost of this type of asset over five years. So each year you can deduct $700 as depreciation (1/5 of the cost of the computer assuming straight-line depreciation is used) on your business tax return.

Next assume the computer was sold at the end of year three for $2,000. This will result in a taxable event that includes depreciation recapture.

This example is simplified for clarity. Actual depreciation methods used will vary from this example. The ordinary income must be claimed on your tax return and is caused because of the depreciation taken in prior years. This illustrates the recapture of prior period depreciation.

When does it occur?

Look for the possibility of depreciation recapture when:

You sell rental property

You sell your home that you have used as a home office

You sell any property used within a small business

Warning: Understand the allowed or allowable trap

One of the land mines surrounding depreciation recapture rules is the concept of “allowed or allowable.” When calculating whether you owe deprecation recapture related taxes, the tax code requires that you adjust for depreciation whether or not you actually took the depreciation expense in prior years. So if you have assets that should be depreciated on your tax return, but are not, please call for a review of your situation.

What you should know

First and foremost, many unsuspecting landlords forget that years of depreciation on their property can impact their tax obligation when the property is sold. This can occur even if the sales price is less than what they paid for the property.